I want to take this opportunity to share with you an interesting observation from the past few months from having discussed risk parity investing with many different retail investors. I want to illustrate the lack of understanding of risk balanced investing with allocation to different market regimes.
As we take on irrational expectations of risk parity, I will be concluding what has now become a mini-three-part series about investor attitudes toward risk parity and investment psychology. Previous posts include a discussion of the most important risks for retail investors and how the All Seasons Portfolio stacks up against the S&P 500.
It may be worthwhile to point out that the retail investors I have had the discussions with, which caused me to write this post, have not been investors I have met through this blog, but retail investors I have encountered through different forums. Namely, I have found that as followers of this website have a rather good grasp of the benefits of risk parity already.
What I have observed, is that there is a great misunderstand of the goals of risk parity, and incorrect expectations of what such strategies should provide.
When explaining what risk parity is, being a strategy that pieces together risk premiums and returns from a wider array of asset classes, but where the timing of the earned positive returns from each asset are spread out in such a fashion that during all economic regimes, some of the assets will see negative returns, but the positive returns of other assets will offset losses and provide your portfolio with an overall profit.
This means that through proper diversification, on a portfolio level you cancel out much of the volatility inherit in each of the individual asset classes, so that you get a much smoother ride with lower portfolio volatility, but can still expect equity-like returns over time. You should expect rolling hills and valleys rather than mountains and canyons.
But as I have alluded to in recent posts, even though the All Seasons Portfolio strategy and other similar strategies (Golden Butterfly, etc. for example) are rationally the best fit for most investors, during times when the stock market outperforms, it becomes difficult to see your neighbor get richer on the stock market while your safe portfolio lags.
This kind of underperformance fatigue sets you up for a great risk if you abandon the safe strategy for a high-risk strategy when the market crash (the one that you were protected against) occurs.
A sketch in the latest paper from ReSolve Asset Management and Newfound Research named “Return Stacking: Strategies For Overcoming a Low Return Environment” (Return Stacking: Strategies For Overcoming a Low Return Environment (investresolve.com)) describes this risk very clearly through a comparison between a 60/40 portfolio against a low-vol portfolio with the same total returns, but where the annual returns differ.
What does this mean? As I see it, this retail investor behavior shows an irrational expectations of safe low-volatility portfolios, such as the All Seasons Portfolio.
Why is this? When discussing risk parity strategies and how these stack up against more conventional strategies (the 60/40 portfolio or an all-equity portfolio) over times, most people agree that it makes sense to cut back on volatility and minimizing drawdowns. They are completely happy with the minimizing the portfolio returns standard deviation around the 7-9% long-term mean.
But in the years when the higher-risk strategies perform better, they get disappointed that their portfolio only gave them what was promised.
Take my portfolio performance over the last year for example. Over the last 12 months from 30 September 2020 to 30 September 2021, my All Seasons Portfolio returned a respectable 9.87%, while the S&P 500 returned 23.44% over the same period.
While a return of almost 10% for a low-volatility portfolio (ex-post volatility of 7.11%, which is half that of the S&P 500 which came in at 14.00%) is in line with the stock market’s long-term average, the uninitiated risk parity investors are disappointed that they “lost” 13.57% against stocks.
What this translates to when considering expectations is that these greedy retail investors are expecting a minimum return of that of the long-term average of the stock market, unless the stock market returns more, in which case the stock market’s return is expected. The result is an absurd 7% floor of annual return that is expected. How this can be achieved, if through dynamically switching between a risk parity strategy and a 100% stock portfolio, I don’t know.
You to illustrate how out of whack such expectation is, I have included here a comparative chart of stock market returns (ex-post) versus stock market returns with a 7%-floor of annual returns until 2020.
Note that the chart is logarithmic, and that the end value for the blue line is 2,058,398.82, while the S&P 500 (including dividends) stood at 5,928.68. That is how strong the power of compounding would be if the minimum annual return was floored at 7%, but now cap was present. Of course, this is impossible.
While this example may be an exaggeration, this is fundamentally an accurate illustration of the expectations of those who abandon risk parity investment strategies when they “only” return like the stock market’s average, and that they only want to participate on the upside of stocks but not the downside.
Hence, such expectations as described when investors get disappointed with risk parity strategies in years when the stock market rallies, but expect the same comfort in bad years, is rather illogical, wouldn’t you say?
To round off this part of the discussion, when making the wiser decision to minimize risk and drawdowns in your portfolio by diversifying between asset classes and by balancing the allocation based on relative risk (volatility) rather than capital exposure, remember that benchmarking against a stock index makes no sense on a year over year basis. The most important thing for you should be to avoid losses and improving your probabilities for positive annual returns.
Another striking comparison was found on Twitter the other week, as @DavidTaggart tweeted this graph, showing your return if you would have missed only the ten worst days in the last 28 years as compared to a buy-and-hold strategy. This was tweeted as part of a market timing discussion, a feat I do not recommend for retail investors, but this also well illustrates hypothetical scenarios were you only cherry pick the days of the market you want to experience. Note also what happens if you accidentally miss the ten best days (green line) if you fail in timing the market.
Much of the above discussion boils down to risk and risk management, which are both important aspects of investing, and one needs to be aware that it is not always so scientific that you can get into a false sense of safety.
Statistics versus reality
Risk is often measured in an asset’s volatility, or in the standard deviations of the daily, weekly and annual returns. But what matters most for at least retail investors is not necessarily the oscillations of an asset around a mean, but rather how great the drawdowns are. At the end of the day, humans are not as rational as the economic man (homo economicus) theory suggest but are very limited by our behavioural nature.
The risk and in particularly the risk management attribute in the S&P 500 and an All Seasons Portfolio are completely different. One cannot simply expect the same size of annual returns in one year for the All Seasons Portfolio as one could encounter on the stock market, but at the same time, the drawdowns for a risk parity strategy are much lower. Over time, both strategies might end up at the same ultimate value, but the road there is rather different (hills and valleys or mountains and canyons). Guess which attribute I consider most important for most investors.
What is the most important aspect in investing for retail investors is to find a strategy that you have a greater chance of actually sticking with. I have found that there is a difficult balance here, as I have discussed already in last months’ posts.
On the one hand, you need a strategy that limits the drawdowns, as it is easy to abandon a strategy when it hurts. For stock-heavy strategies and short-volatility assets, when a huge drawdown occurs, you are bound to be hurt, and in such moment of chaos, it is easy for anyone to deviate from the strategy, by selling at the bottom and not participating in the rebound when the prices revert toward the mean.
On the other hand, there is the issue with benchmarking, that we do not want to do worse than our neighbor, or the S&P 500, or any other stock index we for some reason have elected to benchmark against. During times of low volatility, such as the period between 2009 and 2020, being hedged against low volatility by including gold or cash, like in Harry Browne’s Permanent Portfolio, you have been bound to underperform against those who have only been invested in stocks.
In both scenarios, there are aspects that make it probable for you to make stupid decisions, either by selling out from a stock heavy portfolio in the middle of a drawdown, or by abandoning a strategy that protects you from drawdowns.
Adopting a risk parity mindset is an important key to success, as it balances the risks from different asset classes that perform differently in different macroeconomic regimes. This is achieved by constructing a portfolio of uncorrelated assets.
However, there are two ways of viewing correlation. One is the statistical view where you measure the correlation between assets over a certain period of time. This measure will fluctuate, and some normally uncorrelated assets will at time become more correlated. When constructing a portfolio, one must to some extent decouple from the statistics and math and look at the fundamental (perhaps “theoretical”) correlation.
An example of this is found in the March 2020 crash. Over a few days, risk-on assets such as stocks were well correlated with risk-off assets, such as gold. In theory though, these assets should be negatively uncorrelated, but due to a liquidity crunch and margin calls, levered investors sold the most liquid assets, being gold, to cover the positions in their stocks portfolios. Hence, when liquidity returned, the fundamental negative correlation between stocks and gold returned, and gold proved to be a good hedge in this scenario.
The same market crash also taught us that we need to detach reality from the math of statistics. Even though risk parity strategies to a large extent rely on statistical models, including measuring covariance, correlation, standard deviations, etc., it is not always so that real life aligns with the statistical expectations.
Take the S&P 500 market crash in late February 2020 for example. In that week, the S&P 500 shed about 14% of its value. Such big drops are rare, but how rare? Statistically, this weekly reversal was a 5-sigma move, i.e. the size of the weekly drop was 6 times greater than 1 standard deviation. To refresh your statistics: assuming normal distribution, 68% of data lies within 1 standard deviation, 95% within 2 standard deviations, 99.7% within 3 standard deviations, etc. This means that statistically, a 5-sigma move only happens once every 14,000 years (How Many Sigmas Was the Flash Correction Plunge? | Nasdaq).
But these types of movements are not so rare as statistics would suggest, really. At times, in 2016 for example, several stock indicies saw daily movements in 6-sigma territory, i.e. events that are only expected once every 4,000,000 years on June 24 (High Sigma Events—They’re Not All Black Swans (sixfigureinvesting.com)).
The take-away from this is twofold. Firstly, especially if your portfolio has heavy exposure to stocks, you must understand that great drawdowns are not an anomaly as statistics would suggest, but a feature. You know the saying: the stock market takes the escalators up and the elevator down.
Secondly, regardless if you invest in stocks or with risk balanced strategies, you need to recognize that math and statistical models are only a useful helping tool but it doesn’t tell the whole story. Human behavior and emotion has a much stronger grip on markets than you might think, and thus, it is important to bear in mind aspects like the fundamental correlations between assets and not only the statistically measured ones when constructing a portfolio.
For me, just to mention an example, it has meant that I have include a VIX exposure as an insurance against these larger sigma moves, even though the “insurance premium” causes some drag on performance. Basically, VIX provides protection in the first few days of a crash, before risk-off assets, such as gold, kick in with further protection after correlations in a crash has returned down from going to “1” in the first phases.
Additionally, this is why I find it extremely important to continue being committed to the All Seasons Portfolio strategy, or a similar risk parity strategy of your choice, even throughout periods of low volatility and when stocks do well.
This will keep you prepared to face any macroeconomic environment. Currently, what is feared the most by investors, politicians and economists, is stagflation, that is to say a regime with lower growth and higher inflation. Such regime is often quite harmful for the economy as prices rice, but employment and wages do not keep up. But with a well-diversified investment strategy such as the All Seasons Portfolio strategy, at least your wealth should have a higher probability of staying intact than if you would be investing only in the stock market or with a 60/40 portfolio – both of which are asset classes that are significantly harmed by inflation.
Thank you yet again for following my blog about risk parity investing and the All Seasons Portfolio. If you haven’t done so already, make sure to subscribe to the newsletter via the form in the page footer, and to drop any comments you may have on the content with the comment section or via email to nicholas@allseasonsportfolio.eu. The greatest value I have received from upkeeping this blog is the fantastic conversations with great people, such as yourselves, about ideas on investing and strategies. Thanks for that!
Also make sure to follow me on eToro – a social investing platform – where I invest using an All Seasons Portfolio and regularly share updates about my performance.
If you wish to support me in alternative ways without donations, you can share the post through social media or with your friends who should invest more responsibly.
Cheers,
Nicholas
